Sarbanes-Oxley Act of 2002: An Update on the Provisions That Are Most Significant to Directors and Officers of U.S. and Non - U.S. Public Companies

The Sarbanes-Oxley Act of 2002, signed into law on July 30, seeks to address the precipitous loss of investor confidence in the U.S. capital markets. This loss of confidence by investors is the result of the corporate implosions and financial scandals that have taken place in the U.S. during the past several months. The fundamental regulatory objectives behind the Sarbanes-Oxley Act are threefold: the protection of investors, the maintenance of market integrity, liquidity and transparency, and the promotion of capital formation. These regulatory objectives are based on three core principles: accurate and accessible information, management accountability, and auditor independence. This is the most important securities legislation affecting U.S. public companies since the U.S. Securities and Exchange Commission was formed in 1934. The reforms in the Sarbanes-Oxley Act are broad ranging, including provisions affecting corporate governance, disclosures by public companies, the governance of the accounting profession and enhanced criminal penalties for securities fraud.

The purpose of this article is to focus on those provisions of the Sarbanes-Oxley Act (the Act) that are most significant to directors and officers of public companies.

The Act requires the chief executive officer and the chief financial officer of a public company to make personal certifications in each annual and quarterly report filed with, or submitted to, the SEC. This certification requires that the CEO and CFO certify, to the best of their knowledge, that: (a) each quarterly and annual report is materially accurate and complete, (b) the financial statements in the report present fairly the financial condition of the company and results of operations, and (c) they have evaluated the adequacy of the internal controls of the issuer within the 90 days prior to the date of the report.

The Act provides for criminal penalties only for knowing or willful violations of this provision. A knowing violation by a CEO or CFO of this certification requirement is punishable by a fine of up to 1 million U.S. dollars and imprisonment for up to 10 years, a willful violation raises the maximum fine to 5 million U.S. dollars and imprisonment to 20 years.

The Act prohibits public companies from making personal loans, either directly or through a subsidiary, to executive officers and directors. Existing loans, provided they are not amended or extended, are grandfathered. This ban may even prohibit such customary arrangements as advancing travel or relocation expenses or permitting cashless option exercises.

The Act prohibits public companies, or any officer, employee, contractor, subcontractor, or agent of such company, from discharging, demoting, suspending, threatening, harassing, or in any other manner discriminating against an employee in the terms and conditions of employment for providing information to supervisors, the U.S. government or U.S. Congress regarding conduct that the employee reasonably believes violates U.S. securities or antifraud laws. An employee whose rights are violated under this provision will be entitled to seek relief including reinstatement, back pay and special damages including attorney fees and litigation costs.

If an accounting restatement is required due to the material noncompliance of the company, as a result of misconduct, with any financial reporting requirement under the securities laws, the Act requires that CEOs and CFOs disgorge: (a) any bonus or other incentive or equity-based compensation received during the 12-month period following the first public issuance or filing with the SEC (whichever comes first) of the noncompliant report, and (b) any profits realized from the sale of company securities during such period.

The Act also contains a provision permitting the SEC to obtain a freeze order in U.S. federal court over extraordinary payments to directors, officers or controlling persons during an investigation for possible U.S. securities law violations.

The Act shortens the due date for public company insiders (officers, directors and greater than 10 percent beneficial owners) to report transactions in stock of their company and related derivative securities to two business days after the transaction. Insiders must file their reports electronically, the SEC shall provide each such statement on a publicly accessible Internet site not later than the end of the business day following that filing, and the issuer must post that statement on its corporate website, not later than the end of the business day following that filing.

The Act eases the standard governing judicial imposition of officer and director bars in SEC actions under Section 21(d)(2) of the Exchange Act and Section 20(e) of the Securities Act of 1933 from substantial unfitness to unfitness and now permits the SEC directly, without judicial order, to issue the bar order. In any action or proceeding brought or instituted by the SEC under any provision of the securities laws, the SEC may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.

Prohibition on Insider Trades During Pension Fund Blackout Periods The Act prohibits executive officers and directors from purchasing or selling equity securities of the company during certain black-out periods, as defined in the Act, imposed on a company individual account plan, such as Section 401(k) plans, if such security was or would be acquired in connection with his or her service or employment as an executive officer or director. The Act provides that any shareholder on behalf of the company may institute an action to recover profits if the company fails to bring an action within 60 days of request. The Act also amends ERISA to require plan administrators to provide notice of black-out periods to plan participants and beneficiaries.

The Act directs the SEC to review the periodic reports of each public company at least once every three years and provides criteria for the SEC to consider in prioritizing reviews, including, among others, the occurrence of a restatement, volatility in the stock price of an issuer, market capitalization, and emerging companies with disparities in price-to-earnings ratios.

The Act requires each issuer to disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, as the SEC determines is necessary or useful for the protection of investors and in the public interest.

The Act provides for increased criminal penalties for a broad range of white-collar crimes and an increase in the statute of limitations for securities fraud lawsuits. The statute of limitations for private rights of action with respect to securities fraud is extended to the earlier of two years after the discovery of facts constituting the violation or five years after the violation.

The Act also provides that debts arising from claims that result from violations of securities law cannot be discharged in bankruptcy, imposes criminal penalties for the destruction, alteration and falsification of documents in federal investigations and bankruptcy proceedings, extends the maximum prison term to 25 years for securities fraud, enhances white-collar crime penalties and imposes corporate fraud accountability.

The Act directs the SEC to require the New York Stock Exchange, other U.S. national securities exchanges and the NASD to prohibit the listing of any public company that does not have an audit committee meeting specified criteria. An audit committee of a company must be directly responsible for the appointment, compensation and oversight of the outside auditors of the company, who will report directly to the audit committee. Each member of the audit committee is required to be independent as defined in the Act, meaning that the member will not be able to accept any compensation from the company or be affiliated with the company or any subsidiary of the company, other than in his or her capacity as a director. Each audit committee will also be required to establish procedures for processing complaints regarding accounting, internal controls or auditing matters, as well as the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing practices. Each audit committee must also have the authority to engage independent counsel and other advisors, and the issuer would have to provide funding for this purpose. The SEC is also required to direct public companies to disclosein periodic reports whether the audit committee of the company includes at least one member who is a financial expert, and if not, why not.

The Act directs the SEC to issue rules requiring disclosure of all material off-balance sheet transactions and relationships of the issuer with unconsolidated entities or other personsthat may have a material current or future effect on financial condition. It also directs the SEC to issue rules prohibiting presentation of pro-forma financial information in any periodic report filed with the SEC, in any public disclosure or in any press release unless the pro-forma financial information is reconciled to financial statements prepared in accordance with GAAP.

The Act requires the SEC to establish rules to require each annual report of a public company to contain an internal control report that: (a) states management+IBk-s responsibility for establishing and maintaining an adequate internal control structure and procedure for financial reporting, and (b) assesses, as of the end of the last fiscal year, the effectiveness of the internal control structure and procedures.

The Act requires the SEC to require each public company to disclose in its periodic reports whether it has adopted a code of ethics for senior financial officers, and if not, why not. Any change in, or waiver of, such a code is subject to immediate disclosure on Form 8-K or by dissemination on the Internet or other electronic means.

The Act requires the SEC to establish minimum standards of professional conduct for attorneys appearing and practicing before the SEC. The SEC standards must include a rule requiring an attorney to report to the chief legal counsel or the CEO of the company, evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof, and in the absence of an appropriate response, to the audit committee of the board of directors of the issuer or the entire board of directors.

The Act requires the SEC or, if directed by the SEC, the NYSE or the NASD, to adopt rules to address conflicts of interest arising between securities analysts and investment bankers by: (a) limiting the supervision and compensatory evaluation of securities analysts to officials employed by the broker or dealer who are not engaged in investment banking activities, and (b) establishing structural and institutional safeguards within registered brokers or dealers to assure that securities analysts are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision.

The Act further requires rules to be adopted that are reasonably designed to require each securities analyst to disclose in public appearances, and each registered broker or dealer to disclose in each research report, as applicable, conflicts of interest that are known or should have been known by the securities analyst or the broker or dealer, to exist at the time of the appearance or the date of distribution of the report.

The Act prohibits auditors of public companies from providing nine specific non-audit services to the public companies they audit. Other non-audit services, including tax services, may be permitted if they are pre-approved by the audit committee of the issuer. It shall be unlawful for a registered public accounting firm to provide audit services to an issuer if the lead audit partner, or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the five previous fiscal years of that issuer. The Act restricts the ability of a public company to employ its former auditors and further directs the Comptroller General of the United States to conduct a study of the potential effects of requiring mandatory rotation of registered public accounting firms.

Public Company Accounting Oversight Board

The Act mandates the creation of a Public Company Accounting Oversight Board to oversee the audits of public companies. The Board will operate as a non-governmental, nonprofit corporation and will consist of five full-time, independent members, two of whom must be certified public accountants. Members of the Board will serve for a term of five years, but the terms of the initial members will be staggered so that one would leave the Board each year. No person may serve for more than two terms, whether or not consecutive. The SEC has chosen former FBI and CIA director William H. Webster to lead the initial Board. In addition to Webster, the commission approved in a 4-1 vote the following board members: pension fund lawyer Kayla Gillan, accountant and former SEC general counsel Daniel Goelzer, former congressman Willis Gradison, and SEC Enforcement Division Chief Accountant Charles Neimeier. The Board must be ready to operate by April 26, 2003. Start-up issues for the members of the Board include everything from hiring staff and finding office space to proposing rules and adopting initial and transitional standards. After the Board is up and running, the Board's first order of business will be to register all accountants that audit public companies. The Act provides that this registration process can take another six months and that over this time the principal focus will be on U.S. audit firms. The Board also is charged with establishing standards and rules relating to auditing, quality control, ethics, and independence. The Board will oversee standard setting for auditor conduct and independence, discipline auditors if they err, and perform regular quality control reviews to make sure firms are functioning at the highest professional levels. The Board will work as a complement to the enforcement efforts of the SEC and also focus on ethical and competence requirements.¹

SEC Registered Non-U.S. Companies The Act generally makes no distinction between U.S. issuers and foreign private issuers listed in the United States. However, it is unclear how the provisions of the Act will operate in relation to foreign government and governmental entities subject to the Exchange Act requirements. The Act would not apply to non-U.S. companies furnishing information to the SEC pursuant to Rule 12g3-2(b) of the Exchange Act.

There are a number of provisions of the Sarbanes-Oxley Act that go beyond disclosure. The Act introduces federal law and the SEC into a number of areas of corporate governance and internal corporate activity in ways that are new. Examples include requirements for an audit committee of independent directors for listed companies, prohibitions on loans extended or arranged by a public company to its officers and directors, potential forfeiture by the CEO and the CFO of bonuses and share trading profits, elimination of conflicts of interest and the creation of a Public Company Accounting Oversight Board. Several provisions of the Act are effective immediately. Accordingly, directors and officers of SEC registered companies, both U.S. issuers and foreign private issuers, are advised to immediately evaluate their corporate governance and disclosure policies, accounting practices and relationships with outside legal counsel, investment bankers and analysts.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.